Vox Populi
Increasingly, individuals in the United State are in charge of their
financial well-being after retirement. This is fundamentally a good idea. It is
a basic principle of liberal philosophy that people should be in charge of
their own lives, and that includes saving for retirement and investing their
retirement wealth. It's also a good idea because the financial distress of
pay-as-you-go public pension schemes will make it more and more difficult for
governments to support their citizens' retirements. However, too little
attention is paid to the fact that successfully investing for retirement
requires financial knowledge and competence, and financial mistakes may not
only harm the people who make them, but society as a whole. For example, a
completely clueless investor may ruin himself and his family financially,
ending up elderly and poor. He will also impose a cost on society, since some
form of financial support will eventually be provided by taxpayers. Society has
an interest in helping individuals make good investment decisions.
Annamaria Lusardi (Photo by Joseph Mehling '69)
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The risk is real since financial ignorance is rampant. Evidence from a major
U.S. survey—the Health and Retirement
Study (HRS)—shows that about half of older Americans do not understand the
concept of compound interest and the difference between nominal and real
interest rates. An even larger percentage does not know that investing in a
single stock is riskier than investing in a diversified mutual fund. These
mistakes are often compounded by peer effects: many people follow their
friends' advice in financial matters. A recent study in a leading financial
journal shows that church attendance, a social activity, leads to a larger
propensity to own stocks. Fellow churchgoers like to dispense financial advice
and people listen to them. A clueless investor can also be easily fooled by
unscrupulous financial advisors.
When left to their own retirement saving and investment decisions, people
may simply postpone the decision until it is too late. A striking finding from
the HRS is that lack of planning and lack of knowledge about pension rules is
widespread among American workers. It may be that young people do not plan for
retirement since they face an uncertain future and money may be tight. But the
fact that one-third of older workers have not thought at all about retirement
is not a good sign, since not planning is tantamount to not saving. Lack of
preparedness is also apparent from how little current workers know about Social
Security and pensions. Not only are most workers incorrect about the age at
which they will be eligible for Social Security benefits, but about half of the
older workers surveyed in the HRS do not even know which type of pensions they
have.
How do economies implement a system where workers are in charge? People will
only buy into it if they can benefit from it. A system that limits risk would
be something from which everyone could benefit. Perhaps we could learn
something about steering our financial futures from driving schools, where the
goal is to prepare drivers to obtain their licenses. Why do we require drivers
to have a license? First, we want to be sure they know the rules of the road
and have basic driving skills. Second, knowledge and skills related to safe
driving will decrease the chance that they will do harm to themselves and
others. Like a clueless investor, a reckless driver hurts himself, his family,
and society as a whole.
A financial driver's license issued by each state would not cost much and
does not need to be another large public program. In fact, it could be
administered via a Web page and be based on standardized tests. One does not
need to be a financial wizard to manage his or her savings, just like a driver
does not need to be a mechanic or a Formula One racer to be out on the road.
And, with the same amount of time required to prepare for a driving test,
investors could learn some basic information that could prevent horrible
mistakes. Moreover, rather than listening to random tips, workers would acquire
knowledge about fundamental financial concepts, like diversifying, exploiting
the power of interest compounding, and taking advantage of employers' pension
matches and tax-favored assets.
People should repeat the test if they fail and should show their financial
licenses to their employers. Employers, in turn, could be required to direct
employees without licenses to a default pension plan or to consultations with a
certified financial planner. Acquiring competence and financial literacy will
also empower workers and help them appreciate the potential advantages of an
"ownership" society. Ask yourself: If you weren't required to obtain
a driver's license, would you take the time to read a driving manual before
hitting the road? Maybe. But which one would you read? These are questions that
face investors all the time.
The financial license may be a low-cost way of increasing savings for
retirement and avoiding personal financial disaster. Will financial drivers'
licenses solve all the problems? No. Driver's licenses can't prevent all
accidents. We have already agreed that the benefits of driving with a license
outweigh the risks of the road. In the same way, we are increasingly coming to
understand that the benefits of being able to invest freely as individuals,
with minimum training, outweigh the risk of financial "accidents."
The point is that we are willing to limit risk on the roads because we
recognize the danger to individuals and to society. We should take the same
measures to reduce the risk on household balance sheets.
By ALBERTO ALESINA, professor of economics at Harvard University, and ANNAMARIA LUSARDI, professor of
economics at Dartmouth
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